You are given the following income-expenditures model for the economy of Vulcan.

Question

You are given the following income-expenditures model for the economy of Vulcan. C = 200 + .8Yd T = 25 G = 75 I = 125 a. What is the equilibrium level of income in Vulcan? b. What would the level of expenditures be if the economy were operating at $2000? Make a forecast for the future of the Vulcan economy. c. The policymakers of Vulcan are considering stimulating the economy to offset a decline in consumer confidence. They are debating decreasing taxes by 15 or increasing government spending by 15. Which of these policies (changing T or changing G) will have a greater positive impact on national income? Be specific and show your work. d. To offset Vulcan's fiscal policy changes, the central bank of Vulcan decides to raise the interest rate. Explain how this would impact the money market of Vulcan. Describe ONE monetary policy tool that the central bank could use to create this change in the money market.

Explanation / Answer

a. Y = C + I + G

Disposable income (d) = (Y – T)

MPC here is 0.8

Y = 200 + 0.8(Y – 25) + 125 + 75

Y = 200 + 0.8Y – 25*0.8 + 125 + 75

Y = 200 + 0.8Y – 20 + 125 + 75

Y = 380 + 0.8Y

Y – 0.8Y = 380

0.2Y = 380; Y = 380 / 0.2

Equilibrium level of income = $1,900.

b. 200 + 0.8(2000 – 25) + 125 + 75

AE = 200 + 0.8*1975 – 20 + 125 + 75

AE = 200 + 1580 – 20 + 125 + 75

AE = $1960

Aggregate income exceeds that of aggregate expenditure. The Vulcan economy is in surplus when it is operating at the level of 2000.

c. If taxes are decreased by 15:

Y = 200 + 0.8(1900 – 10) + 125 + 75

Y = 200 + 0.8*1990 + 200

Y = 400 + 1592

Y = 1992 (Income above equilibrium level)

If expenditure is increased by 15:

Y = 200 + 0.8(1900 – 25) + 125 + 90

Y = 415 + 0.8*1875

Y = 415 + 1500

Y = 1915

Therefore, changing T will have a more positive impact on Vulcan’s national income.

d. The most influential economics tool that the central bank has under its control is to make changes in the discount rate. When the central bank increases the interest rate, banks have little room to borrow, lending to the public will be tightened, and consumer spending shrinks on account of this tactic. Yet another popular tool to increase interest rate is central banks sell securities. Changing interest rates can stimulate economic growth and fight inflation.

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